Asset Classes: Funds


Kerry Back

BUSI 721, Fall 2022
JGSB, Rice University

Mutual Funds

  • Easy way to get diversification

  • Can also perhaps benefit from professional active management

  • Can usually invest directly with no need for a brokerage account

  • Over 7,000 U.S. mutual funds \(∼\) number of U.S. stocks

Net Asset Value

  • NAV (net asset value per share) is calculated daily after close of trading.
  • Equals value of portfolio less any expenses not yet paid divided by number of shares outstanding.
  • Invest money \(\rightarrow\) get shares in fund at next end-of-day NAV
  • Withdraw money \(\rightarrow\) sell shares at next end-of-day NAV.

Why Next-End-of-Day NAV?

If you could buy/redeem shares at a prior NAV (e.g., Wed night at Wed close) then you could

  • Profit by investing when prices are up in after-hours future trading or trading in Asia, indicating that true values are higher than prices used to compute the NAV,
  • Profit by redeeming shares when prices are down in after-hours or Asian trading, indicating that prices used to compute the NAV are higher than true values.

Example

Invest $10,000 on Wed night, Thursday end-of-day NAV = $250, get 40 shares

# of shares can be fractional

  • Fund \(\uparrow\). Withdraw $6,000.
  • Next end-of-day NAV is $300.
  • Cancels 20 shares. Still have 20 shares (worth $6,000).

Active and Passive Funds

  • Passive funds track an index. They do not try to “beat the market.” They have low expenses.
  • Active funds try to beat the market or their market sector by choosing the best stocks. They have higher expenses.
  • There is some evidence that active fund managers can pick good stocks. But there is little evidence of extra returns to investors, after payment of managers’ fees.

Some Famous Funds

Vanguard Fidelity
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Some U.S. Stock Indexes

  • Dow Jones = 30 stocks
  • S&P 100 ~ 50% of U.S. stock market capitalization
  • S&P 500 ~ 80% of U.S. stock market capitalization
  • Russell 1000
  • Russell 3000
  • Russell 2000 = Russell 3000 excluding Russell 1000, small-cap index
  • Wilshire 5000

% change in index is % increase/decrease in total value of companies in the index (except for Dow)

% change in index does not include dividend return

Many of the 7,000+ U.S. mutual funds hold assets other than U.S. stocks such as:

  • corporate bond funds
  • municipal bond funds
  • U.S. government bond funds
  • global bond funds
  • global stock funds
  • emerging market funds
  • REIT funds (real estate)
  • money market funds
    \(\cdots\)

Exchange Traded Funds (ETFs)

ETFs were invented in 1990. There are now \(∼\) 3,000 U.S. ETFs.

ETFs are listed on stock exchanges and trade like stocks. You buy/sell them through your broker.

Another easy way to get diversification. Lower fees than mutual funds.

ETFs calculate NAVs daily, but you do not buy/sell at the NAV. You buy/sell at the price determined by the market.

Types of ETFs

  • Stocks - U.S., global
  • municipal bond funds
  • U.S. government bond funds
  • global bond funds
  • global stock funds
  • emerging market funds
  • REIT funds (real estate)
  • money market funds
    \(\cdots\)

Levered = 2 or 3 times return
Inverse = minus the return or levered return

Market Prices of ETFs

The market price of an ETF will be close to its NAV.

When the price is lower, authorized participants (APs) buy shares at the low prices, redeem them with the ETF sponsor for a piece of the ETF portfolio, and sell the assets at the higher NAV.

Buying shares causes ETF prices \(\uparrow\).

When the ETF price is higher than the NAV , APs do the opposite: buy assets of the type held by the ETF and turn them in for new shares, then sell the shares.

Selling shares causes ETF prices \(\downarrow\).

Transparency of ETF Strategies

Because of the mechanism for APs to redeem or acquire shares, an ETF’s portfolio must be transparent.

So, active strategies of the type typical for mutual funds (who only report portfolios quarterly) are not possible.

Nevertheless, complex strategies are possible. For example, some ETFs focus on “quality stocks” or high momentum stocks or the like.